As Greece goes, so goes Italy?

With the Greek crisis coming to a head this week, traders in Europe have started to worry about the fiscal health of other eurozone members. Now the worry has moved up the scale to one of the core eurozone members: Italy.

A sovereign default in the world’s third-largest public debt market would be catastrophic. While such a default doesn’t appear imminent, there is growing fear on European trading desks that a default may occur sometime down the road — set off primarily by troubles in the nation’s banking sector. Traders are scrambling to hedge their exposure to the country and its banks just in case the unthinkable happens sooner rather than later. This panic could spread to other core eurozone members if the Italians fail to make a serious effort to rein in spending.

There’s a panic of sorts sweeping through European trading desks concerning all things Italian. Moody’s has said that it may downgrade the country’s debt due to macroeconomic structural weaknesses and the economic turmoil in neighboring countries. And last Thursday the ratings agency said that it might downgrade 13 Italian banks if the nation’s sovereign rating was cut.

The market initially ignored the Moody’s report, but by midday on Friday traders started to “de-risk” their portfolios en masse. There was a mad dash to buy up protection against Italian debt using credit default swaps. Other traders then started to dump their Italian bank stocks and head for the hills. UniCredit and Intesa SanPaulo, the two largest banks in Italy, saw their stocks fall 10% in the panic, setting off circuit breakers, suspending trading. They later settled the day down 5.5% and 4.3%, respectively, once trading resumed. Meanwhile, the spread between Italian and German 10-year bonds widened to 212 basis points, its highest level since the creation of the euro.

The Italian banks have troubles, but they seem to be acting as a proxy for the general health of Italy’s sovereign debt. After all, they hold more than 150 billion euros of the stuff. On Monday, calm seemed to have set in with some of the Italian banks up slightly from Friday’s close. But Friday’s panic has clearly shaken the market’s confidence in Italy.

“Most Dutch and European banks are worried and are not accepting Italian [debt] as collateral and reducing overall exposure in anything southern European,” a trader at a major Dutch financial firm tells Fortune. “Even the Dutch pension funds are avoiding it.”

Italy was forced to pay a much higher interest rate to investors when it came to the market to sell new debt on Monday. The Italian treasury sold 8 billion euros in six-month bonds at a yield of 1.988%, which is up sharply from the 1.657% paid during the last sale of government debt. Yields on bonds maturing in 2013 were issued at 3.219%, up from 2.851%.

Roots of the crisis

Italy’s main economic problem doesn’t stem from a large fiscal deficit, as is the case with the other troubled eurozone members. What worries economists and traders is the nation’s very high debt-to-GDP ratio emanating from structural inefficiencies in its economy. This has led to decades of declining productivity and poor growth.

Italy’s current debt load is around 1.8 trillion euros, making it the fourth-highest public debtor in the world. Having debt is not a bad thing; it just becomes a problem when the amount of debt on the books exceeds productivity. The nation’s debt to GDP ratio stands at an alarming 120%, the second-highest in Europe after Greece at 140%. To put that into perspective, Italy’s ratio is double that of Spain.

Overspending is of course a problem, but the ratio has popped up recently due to anemic economic growth in the country. Italy’s real GDP shrank by 1.3% in 2008 and a whopping 5.2% in 2009. To make matters worse, the unemployment rate has increased by more than two percentage points since the beginning of the financial crisis and stands at around 8.3%, with youth unemployment at around 29%.

Italy has a number of problems it needs to deal with to get its house in order. It needs to cut waste, grow its economy and due a much better job of collecting taxes (the Italian government estimates that tax evasion will cost the nation 120 billion euros in 2011). A strong euro is hurting the country’s exports, which accounts for around 30% of Italy’s GDP, a very large number.

The Italians are moving to cut spending. The government is targeting a budget deficit of 3.9% this year, down from the 4.6% last year. This week, Prime Minister Silvio Berlusconi plans on holding a vote on austerity measures meant to wipe out the budget deficit by 2014. The 43 billion euros in cuts that have been proposed are deep, with most of the pain pushed down the road. It is widely believed that Berlusconi will be successful in getting the austerity measures through the Italian Parliament, but there has been some grumbling from members in his coalition government who believe that the proposed cuts go too far.

Cutting spending, though, is just one part of the equation. Italy needs to revamp its economy to put it on a strong growth path. This is where it gets tricky. The Italian economy isn’t really cutting edge – how many Italian tech firms can you name? It moves manufacturing and tourism, both hurt by the strong euro, and has an aging population who demand higher wages.

To get its house in order, the analysts at Barclays (BCS) believe that the government should increase the retirement age, simplify the tax system and adopt clear budgeting ceilings. They also believe the government should take further measures to enhance labor market participation and should reduce public ownership of some the nation’s largest corporations. The analysts believe that this should encourage foreign direct investment inflows in to the country to help dig it out of its debt hole.

But such structural reforms will be hard to accomplish as it becomes increasingly more expensive to service new debt. Every percentage point increase in borrowing costs makes it that much harder to get the nation’s fiscal house in order. For now, the interest rate demanded on Italian government debt is manageable. But if Berlusconi doesn’t move fast to address the structural problems in Italy’s economy, the rate could skyrocket up, handicapping Italy’s chances in avoiding a devastating default.

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